ADP: Why This Dividend Growth Stock Is Near The Top Of My Watch List

Warren Buffett’s investing Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.

Early In my investing life, I strived to adhere to Buffett’s first two principles of investing, but a lack of experience and understanding tended to lead me astray. I often invested in value stocks that eventually translated into poor investments. However, decades of experience taught me to identify companies that are likely to outperform.

Automatic Data Processing, Inc. (NASDAQ:ADP) possesses the hallmarks of a long-term winner. Some of the boxes ADP checks include a wide-moat business, a very strong financial foundation, a market that has reasonable growth forecasts, and a long history of growing dividend payments.

Add to that list the solid results reported last quarter, a bump in guidance, and a 20% increase in the dividend.

An Overview

Based on revenue, ADP is the largest provider of payroll outsourcing services in the world. Although ADP is best known as a payroll processor, the company also provides a variety of corporate human-resources department software. This includes benefits-management solutions. time and attendance tools, and recruitment tools.

ADP has two primary segments: Employer Services (ES) and Professional Employer Organization Services (PEO).

ES is a global provider of human resource, payroll, benefits administration, tax filing, and time and attendance services. The company provides these services to both small businesses and large enterprises. ES generates roughly two-thirds of the firm’s revenue.

The PEO Services segment revolves around a service known as ADP TotalSource. TotalSource offers a co-employment relationship in which ADP manages the administration of benefits and HR while the client business maintains day-to-day control over the employees.

ADP’s PEO network is the largest in the United States with more than 620,000 worksite employees in 50 states.

ADP has more than 1,000,000 clients in over 140 countries and territories, including North America, Europe, Australia, Asia, and Brazil.

A Review Of Last Quarter’s Results

ADP reported Q1 2023 results near the end of October. The company beat on the top and bottom line with Non-GAAP EPS of $1.86 topping estimates by $0.07. Revenue of $4.2 billion, up 9.7% year-over-year, was above consensus by $40 million.

By segment, ES revenues were up 9% , and PEO Services revenues increased 13%.

Included within the results of the two segments are Interest on Funds Held for Clients. Compared to last year’s first quarter, interest on funds held for clients increased 39% to $141 million. The average client funds balance grew 9% to $29.4 billion, and the average interest yield on client funds increased 40 basis points to 1.9%.

This follows FY22 revenue growth of 10% and an annual increase in EPS of 16%.

The strong results led to management updating the outlook for fiscal ’23. Revenue growth for FY 23 is forecast in a range of 8% to 9%, versus the prior 7% to 9%. Adjusted diluted EPS is expected in a range of 15% to 17% from the prior outlook of 13% to 16%.

Roughly two weeks after the earnings call, ADP bumped the quarterly dividend from $1.04 to $1.25 a share. The board of directors of ADP also authorized a $5 billion stock buyback program. The firm’s current market cap is approximately $99.2 billion.

Growth Forecasts

AlliedMarketResearch forecasts a CAGR for the Human Capital Management market from 2022 through 2031 of 9%.

Verified Market Research projects a CAGR for the Human Resources Market of 10.17% from 2022 through 2030.

Debt, Dividend, And Valuation

ADP’s debt is rated Aa3/stable by Moody’s and AA-/stable by S&P.

The dividend has been raised for 48 consecutive years. If the company increases the dividend for two more years, that would earn the ADP the title of Dividend King.

The current yield is 2.09%, the payout ratio is 57.62%, and the 5-year dividend growth rate is 13.31%.

ADP trades for $240.92 per share. The average one year price target of the 6 analysts that rate the stock is $243.09. The average price target of the 4 analysts that rated ADP following the most recent earnings report is $254.50.

ADP’s forward PEG is 2.12x, slightly below the stock’s 5-year average PEG of 2.28x. The forward P/E is 29.21x, nearly in line with the 5-year average P/E ratio of 29.50x.

Is ADP A Buy, Sell, Or Hold?

ADP has a history of retaining client businesses at a high rate. This is evidenced by the ES segment’s retention rate of 92.1% in FY 2022.

This is in part due to high switching costs. Furthermore, payroll and HR software is oftentimes an integral part of a business. Switching to a competitor’s services could result in inefficiencies and a disruption of operations, including the costs and time involved in training employees in the new system, as well as the possibility of data losses.

As the largest global provider of payroll outsourcing services, ADP also benefits from cost advantages due to economies of scale.

In spite of, or perhaps in part due to its dominant position, ADP has grown at a marked pace. Total revenue has increased from approximately $12.8 billion in 2018 to over $16 billion in 2022.

Evidence of continued growth can be found in the firm’s recent results. For example, in Q4 of 2022, the number of worksite employees for the PEO segment (those in a co-employment relationship with TotalSource) increased by 14%.

The only negative I can see in ADP is the current valuation, which I believe does not provide a margin of safety. Consequently, I rate the stock as a HOLD.

Nonetheless, ADP is near the top of my watchlist. With uncertain prospects for the economy and the market in the months ahead, I am hoping the Automatic Data Processing, Inc. share price will fall to a level that would allow me to invest in this outstanding company.